May 18, 2011

Is the 30-Year Mortgage On Its Last Legs?

Financial planners and other prudent financial “types” have long held a grudge against the 30-year mortgage, and with good reason. The (now) standard 30-year mortgage term has cost Americans, on the whole, unfathomable sums of money since they became, well, standard. Banks have historically loved the longer-term mortgages because they ultimately put far more money into their pockets, and financial advisors have despised them for that same, exact reason.

Now, the very survival of the 30-year mortgage mechanism is at risk, thanks to the economic upheaval that we’ve all come to know so well. Beyond the tightening of underwriting standards overall, Fannie Mae and Freddie Mac, the “government-sponsored entities” that have gone such a long way to fueling the American Dream of home ownership through their mission of implicitly guaranteeing mortgages and thus keeping them cheap and easier to obtain, are faced with the very real prospect of seeing themselves drastically reduced or even eliminated outright. Should that happen, the cost of the mortgages would likely rise, and jeopardizing the only real benefit that mortgage term offers: the lowest payment available, in general.

This is good news, truthfully. Although I believe the 30-year mortgage will remain among us in some form or fashion, as even without any government backing, the free market will keep it available for those who can pass the new, more stringent underwriting standards that will accompany it, the point is that it has always been a bad deal. It has led people to pay far, far more for their houses than they should, and demands that homeowners wait years to build up any real equity because of how slowly the loan amortizes.

Frustratingly, one of the reasons people have so quickly opted for 30-year mortgages is due to a simple lack of awareness of how the time value of money really affects a mortgage payment when the mortgage term is adjusted for varying lengths. A lot of people are aware that the longer the mortgage term, the lower the monthly payment, which is pretty obvious because the repayment period is spread over decades. So, right off the bat, “lower” always equals “better” for most people. The Part B to this, however, is that when people consider the possibility of a 15-year mortgage instead of a 30-year mortgage, they make the mistake of assuming that because the repayment period is cut in half, that must mean the payment doubles. It doesn’t. It is certainly higher, but it is not even close to being twice that of the 30-year payment.

Here’s a quick example. If you buy a $200,000 house with a 30-year mortgage at 5.5% fixed, the monthly payment (principal and interest) is $1,135. If you buy the same house with a 15-year fixed mortgage that’s priced at 4.5% (the interest rates on 15-year mortgages are often about a point less than those on 30-years), the monthly payment is $1,529. Higher, for sure, but nowhere near double that of $1,135. In fact, it’s about $400 per month more. In exchange for agreeing to a monthly payment of $1,529 instead of $1,135, the buyer could own the home outright in half the time, and pay a lot less for the privilege. How much less? The $200,000 home, financed for 30 years at the terms noted above, will ultimately cost a grand total of $408,000 when it’s all said and done. The same $200,000 home financed for 15 years at the terms noted will ultimately cost the buyer $275,000. So, for an unwillingness to find a way to come up with another $400 per month, the 30-year buyer…the “standard” buyer…will pay an additional $133,000 for the same house over what the 15-year buyer pays.

One of the silver linings of the recent economic collapse is that the population seems generally more aware about things like debt management, and how much debt costs in the long run. More generally, we’re all, it seems, getting a just a little smarter about money and how it works, and less tolerant of the way things have been done for years. This increasing consumerism is going to save us a lot of dough in the long run, and it’s high time that we look to applying this new outlook to the most expensive single purchase we will ever make. Refer back to the example I cited above. If you can pay $1100 a month for a house, then you can probably pay $1500; if you cannot, then it’s probably less a case that you absolutely cannot not, and more the case that you’ve decided to apply that additional $400 to something else. Now you have to ask yourself this question: Is whatever I’m spending that additional $400 a month on now something that’s worth me taking an additional 15 years to eliminate my mortgage altogether, and spending another $133,000 more than I have to?

Bob Yetman, Editor-at-Large at Christian Money.com (www.christianmoney.com), is an author of a variety of materials on personal finance and investing, as well as on topics of fitness and self defense, to include the book Investor's Passport to Hedge Fund Profits (John Wiley & Sons, Inc.) and the unarmed combat training DVD Thunderstrikes - How to Develop One Shot, One Kill Striking Power (Paladin Press).

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I believe you are right a 15 year Mortgage is better than a 30 year Mortgage Loan you will save a lot of money in a shouer run that is the 15 year,
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